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Bankruptcy Creditors Can Reach Inherited IRA

Posted on Oct 20, 2016 1:41pm PDT

On June 12, 2014, the Supreme Court unexpectedly provided
yet one more reason why you should designate a trust as beneficiary of your IRA rather than
simply designating one or more individuals as beneficiaries.

In a unanimous opinion affirming a decision of the 7th Circuit, the Court in
Clark v. Rameker ruled funds held in an inherited IRA are not protected from creditors
in bankruptcy.

In 2001, Heidi Heffron-Clark inherited an IRA from her mother with a date
of death value of $450,000. She began taking the required minimum distributions
from the account, calculated with reference to her life expectancy. So
far, so good.

By 2010, the IRA was down to $300,000. Ms. Heffron-Clark and her husband
ran into money troubles and filed for bankruptcy under Chapter 7. They
claimed the inherited IRA was a "retirement account" under the
bankruptcy law and thus exempt from creditor claims.

The bankruptcy court disagreed, but the district court reversed. But then
the appeals court reversed the district court. Back and forth. The Clarks
took the matter to the Supreme Court, citing a conflict among the federal
appeals courts on the issue.

Writing for a unanimous Court, Justice Sotomayor said there were three
reasons an inherited IRA is not a "retirement account" exempt
from creditor claims in bankruptcy. First, the holder of an inherited
IRA may not put more money in the account, as she might with her own IRA.
Second, she is required to start withdrawing funds shortly after the death
of the original IRA owner, regardless how many years she might be from
retirement herself.

Third, the holder of an inherited IRA might withdraw the entire account,
for any purpose, without incurring the ten percent penalty she would incur
if she took money out of her own IRA before reaching age 59-1/2. And she
might do this the day after the bankruptcy proceeding closed.

Even before the
Clark ruling, the first concern for most IRA owners in planning to leave an
undistributed balance to a child or other beneficiary has always been
how to protect the fund from being depleted by a spendthrift, or exposed
to the claims of creditors or divorced spouses.

Under the required minimum distribution (RMD) rules, an inherited IRA may
be "stretched out"
over the life expectancy of the beneficiary. This almost always results in the lowest income taxes
and the highest total value to the beneficiary. However, if the account is left
outright rather than in trust, the beneficiary can take out as much as she wants immediately, without
waiting for the minimum distributions. She would incur a substantial income
tax, possibly at higher marginal rates, and she would lose the benefit
of tax-deferred compounding, but she could do it.

After the
Clark ruling, we now have the additional concern that the beneficiary's
creditors may reach the inherited IRA -- in a joint bankruptcy, such as
the Clarks, the creditors of either spouse.

To state it more bluntly: before
Clark you had to worry that your daughter might withdraw your entire IRA to
fund her boyfriend's brewpub, or that your son might need to use your
IRA to buy an "emergency" Corvette. Now you have to worry not
only about those scenarios, but also that your IRA might end up paying
for debts incurred by your son-in-law or daughter-in-law, even if your
own child was sensible enough not to invade the account.

A competent planning lawyer knows how to anticipate these risks and to
plan to protect you and your family from them.
Contact us today for more information.